price gouging

In my previous post on this subject I argued that the critics of “anti price-gouging laws” are mistakenly assuming that is possible to satisfy demand at the pre-natural disaster price. That is, sadly of course, fiction. It it not our reality anymore and we are better accepting the new situation than blindly deny it. As many economists are explaining these days, to not let prices increase after a natural disaster does more harm than letting prices increase. This can easily be seen in a demand and supply graph.

Consider first just the lines in black. Those lines represent the pre natural disaster situation. What is considered “normal prices”. At price p0, a quantity q0 of a good is traded in the market (i.e. bottles of water.)

Now there is a shock. A hurricane hits this region and demand increases (shifts to the right). This is the demand line in color red. The red dotted line that extends to the right shows the size of the shortage (q2 – q1) at the “normal and fair” price.

Price gouging is an emotional loaded word, but it doesn’t have any specific economic meaning. How does “price gouging” show up in this graph? It is the increase in price from p0 to p1. This is the increase in price required to satisfy the higher demand and provide the extra number of goods (q1 – q0). No… supply is not horizontal.

What happens if price increases are banned? Then at the pre-crisis quantity (q0), consumers are willing to pay p2, a price even higher than price gouging. This means two things. First, a number of people in need will be unable to acquire the goods (the empty shelf problem). Second, that the actual total cost (to those who acquire the quantity q0) is p2, not p0. The difference between the price in the store and total cost falls into waiting in long lines, visiting a long number of stores, bribing producers (yes… with natural disaster price controls also lead to black markets), calling favors., etc. Any principles of microeconomic textbook has plenty of more examples under the price ceiling discussion.

There are three scenarios being discussed here.

Quantity q0 at price p0

Quantity q1 at price p1

Quantity q0 at price p2

The natural disaster makes scenario 1 impossible. And it is not clear that scenario 3 is better for those in need than scenario 2. Less goods are provided at a higher total cost than in scenario 2.

One final remark. Note that in this analysis the natural disaster only affected demand. Of course, it is quite likely that supply would also be affected. The point, however, is to show that prices are not pushed up only by produces. As we can see in this case, it is consumers who are increasing the price and producers reacting to the new behavior of consumers.

Like this:

In a previous post I comment on a too common economic fallacy, that a natural disaster is good for the economy because of its alleged impact on GDP. Economic fallacies are not the only misconceptions gaining momentum during a natural disaster, but a confusion between reality and fiction becomes also quite common. The issue of price gouging provides a good example of this situation.

After a natural disaster, the price of certain goods such as water or gas, increases significantly. This is seen as an immoral exploitation by merchants who are taking advantage of the people affected by the natural disaster. Even though in this post I want to comment on another issue, it is worth mentioning that the now limited resources should be allocated to those in most need (rather than, for instance, to whoever happens to be the first one in line.) And unless someone has a crystal ball, there is no way of knowing who is in most need without changes in relative prices.

The mention to reality versus fiction refers to the fact that the critics of price gouging seem to (implicitly) assume that the natural disaster did not occur. It is plausible to assume that an event like this would (1) shift the supply to the left [reduce supply of goods] and (2) shift the demand to the right [increase the demand of goods.] At the usual (or “normal”) price these goods are in serious shortage.

This means that in the event of a natural disaster the option is between (1) having goods at a higher price or (2) not having goods at the “normal” price. This is the new reality. The old and normal reality does not exist anymore. To limit price gouging results in a lower price in the store, but not goods on the shelf. This would not help those in need. The fiction consists in thinking that a larger supply can be secured without an increase in the price (why should we assume supply is horizontal when these goods usually have a low elasticity?) An efficient policy would secure the provision of goods rather than secure a low price without the goods. Reality, rather than fiction, should be the first driver of a policy designed to assist during a natural disaster. As Milton Friedman insisted, a policy is to be valuated by its results (or design), not by its intentions.

The first rule for an efficient policy should be to not get in the way of changes in relative prices. Otherwise help will become erratic and inefficient. It might be more efficient, for instance, to make use of firms specialized in logistics (i.e. firms such as Walmart) and subsidize the demand than start a price control policy. For instance, a tax credit or a check can be sent to those affected by the natural disaster allowing them to pay the now higher prices. Similarly, a subsidy can be given to those firms bringing goods to the damaged areas (who says the government has the monopoly of charity or that the only one who can do it efficiently?) A policy on these lines would be more efficient than interfering with relative prices.

However, some opponents of price gouging seem to be more interested in damaging merchants than in making sure resources will be efficiently allocated among the ones affected by the natural disaster. Those who do not oppose price gouging do so because they have the affected ones first in line. It is not about merchant’s revenue, it is about allocating goods efficiently. Damaging the merchants should not be more important than worsening the situation of those in need.

On one sunny August 16, at a time of high price inflation, government operatives announced the seizure of millions of eggs and 200,000 pounds of sugar. Raids on the larders of other suspected profiteers continued for weeks thereafter … The government was prepared to return these items to their owners once the chastened profiteers agreed to sell them at a “reasonable” price and under the watchful eye of a government officer.

The official in charge of the raids explained thusly: “I am one of those who believe that a large part of the high cost of living is due to the fact that a number of unconscionable men in the ranks of the dealers have taken advantage … If we can make a few conspicuous examples of gougers and give the widest sort of publicity to the fact that such gougers have been and will be punished, in the future there will be little inclination to profiteer in this country.”

Earlier, the President of the Republic had laid the blame for a lesser bout of price inflation squarely at the feet of gouging businessmen: “The high cost of living is arranged by private understanding” is how he put it.

By now you may have guessed that I am talking about present-day Venezuela, its Presidente, and his henchmen. You would have guessed wrong. The year was 1919, Woodrow Wilson was president, and his henchman, quoted above, was Attorney General A. Mitchell Palmer. The high cost of living was a result of Mr. Wilson’s war, which was financed partly by money printing, as well as the absorption of vast quantities of real goods and services by the government for use in fighting the war. The obvious effect of more money chasing a reduced supply of goods and services was price inflation, and that same phenomenon happened in all the warring countries, most notably France.

The first three paragraphs above are paraphrased from p. 24 of James Grant’s new book, “The Forgotten Depression.” Though I have not finished the book, I couldn’t resist sharing this tidbit. The gist of Grant’s thesis can be seen in its subtitle, “1921: the Crash that Cured Itself.” Highly recommended, so far.